Endowment assurance products-effectiveness of riskminimizing strategies under model risk

This paper analyzes and discusses the effects of model misspecificationassociated with both interest rate and mortality risk on the hedging decisions ofinsurance companies. We consider hedging strategies in different instruments (zerobonds) which are risk–(variance–)minimizing with respect to an assumed model. Inthis case, the associated expected costs and the variance of the costs are the samefor all strategies. While the introduction of model risk, i.e. a deviation of assumedfrom true models, has the same effect on the expected costs, this is not true withrespect to the variance. It turns out that the choice of hedging instruments has acrucial impact on the robustness of the strategies. In addition, the results of thepaper can be used to emphasize the necessity to use a combined hedging model. Interms of robust hedging, a separate specification of interest rate model and mortalitymodel is inconvenient, even in the case that interest rate and mortality areassumed to be independent.